I’ve received several questions about college savings in recent weeks, and thought this would be a good time to help parents think through two main alternatives for funding college.
For tax-friendly college savings, 529 plans and Coverdell Education Savings Accounts (ESAs) are great options. They both offer:
- Tax-deferred savings: your contributions grow tax-free along the way, keeping more money in the account to grow over time.
- Tax-free withdrawals: both contributions AND earnings can be withdrawn without paying tax, as long as the funds are used for qualified educational expenses like tuition, room, board, supplies, and so forth.
- Beneficiaries: the beneficiary can be changed, so if the first beneficiary doesn’t need the funds, the account can be used by a brother, sister, step-brother, step-sister, father, mother, grandparent, aunt, uncle, in-law, or spouse. Foster children/siblings and adopted children/siblings are included, too.
- Non-qualified withdrawals: if your child doesn’t need the money you’ve saved and you don’t have a family member who needs the funds, you can take all of the money back, including the earnings. The contributions are not taxed, but the earnings are taxed at your ordinary income rate and you have to pay an additional 10% penalty on the earnings.
- Financial aid: if a parent owns the account, it counts as that parent’s asset on the Free Application for Student Aid (FAFSA). If the account is owned by a grandparent, it would not be included on the FAFSA when the student applies for aid. Withdrawals also do not count as income.
- Contributions: anyone can contribute to a 529 or Coverdell ESA, meaning that parents, grandparents, aunts, uncles, brothers-in-law-twice-removed and generous friends can all help out.
- Elementary and high school contributions: the funds from both a Coverdell ESA and a 529 can be used to pay for qualified elementary, high school, and college expenses.
There are some differences between 529s and Coverdell ESAs:
- Deductibility of contributions: Contributions to a 529 can be deductible on state income tax returns in certain states (sorry, Washington, but at least you don’t have to pay state income tax). Coverdell ESA contributions aren’t deductible.
- Contribution limits: only $2,000 can be contributed to a Coverdell ESA each year as of 2019, no matter how many people contribute or how many Coverdell accounts you open. Only $2,000 can be contributed for any one beneficiary per year. The limit for 529s is just the estimate of the beneficiary’s total qualified education expenses, so you can see that 529s allow for much higher contributions.
- Can you have both? Yes, you can open both a Coverdell ESA and a 529 for one student and the same maximum contribution limits apply.
- Gift tax: just keep in mind that contributions to both ESAs and 529s count as gifts, so if any one person contributes more than the maximum gift tax exclusion per year toward college savings, that person has to file a gift tax return. To figure out this year’s gift tax exclusion amount just do a web search.
- Income limits: Coverdell ESAs have income limits, meaning that above a certain level of Modified Adjusted Gross Income you are not allowed to contribute. There are no income limits for people contributing to 529s. You can also look up the current year’s income limits for Coverdell contributions online.
- Age limits: contributions to a Coverdell ESA must stop when the beneficiary turns 18 and the funds must be used or rolled over to another beneficiary by the time the beneficiary turns 30. There are no age requirements associated with a 529.
- Investments: Coverdell ESAs can be invested with any broker you like, in any investment vehicle you like. You can also change investments at any time. With 529s, you can only invest in the plans available to your state, and investment changes are allowed only twice a year. Click here to find a list of plans available to Washington residents, for example.
Of course there are other nuances to Coverdell ESAs and 529s; this is just a quick summary of the basics. And there are many other ways to save for college, including UTMA accounts, brokerage accounts, regular savings accounts, and CDs. The appropriate college savings vehicle will depend on a variety of factors.
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